Category Archives: Economics

Transfer Pricing – Do You Know What You Need To?

Transfer pricing, which allocates profits and losses among different parts of a multinational entity for tax and related purposes, can have a significant financial effect on your supply chain because the companies in a commonly controlled supply chain must comply with transfer pricing rules and regulations in determining what companies should recognize what amounts of income, deductions, credits, and allowances among the various tax jurisdictions.

Transfer pricing regulations, which are governed under section 482 of the tax code that authorizes the IRS to adjust the income, deductions, credits, or allowances of commonly controlled taxpayers to prevent evasion of taxes in the US, and which must follow OECD Transfer Pricing Guidelines, can be quite complex, but as this recent article in Industry Week on “what manufacturers need to know about transfer pricing”, most regulations are based on one underlying principle: the arm’s length principle.

The arm’s length principle is the condition or the fact that the parties to a transaction are independent and on an equal footing. Transactions based on the arm’s length principle are arm’s length transactions and used in contract law to arrange equitable agreements that will stand up to legal scrutiny, even though the parties may have shared interests or are too closely related to be seen as completely independent. The principle requires that the amount charged by one party to another (related) party must be the same as it would be if the parties were not related. An arm’s length price is the same price that an independent company would pay for a good or service.

This sounds pretty easy until you get into international transactions when trying to split profits and you have to figure out who bears the product liability, the risk of currency fluctuations, and so on. At this point, most multinationals will use a transfer pricing study that performs a detailed analysis of the functions performed, assets employed, and risks borne by each party in the transaction. This will provide a justification of the cost breakdown that will stand up to regulatory and legal scrutiny.

For more information on transfer pricing, see the Transfer Pricing Network in the US, the Cole & Partners Transfer Pricing Site in Canada, or the Transfer Pricing Forum in the EU. Understanding the profit breakdowns will help you understand the cost savings that Procurement directly and indirectly generates for the supply chain.

Don’t Go Gaga Over Global Trade Numbers

Global Trade may be growing, but it’s not growing as fast as the WTO wants you to believe. You have to take the long term view. Global Trade may have increased 13.5% last year, but this followed a year where it dropped 12.2%. Just like an elastic will snap back when released, it is only logical to expect that global trade would snap back to pre-recession levels once the world, and the US in particular (which alone controls 25% of Global GDP) started to work its way out of the recession. And that’s all it did … snap back. (If it was at 100$, and it dropped by 12.2%, then it was at 87.8$. If that increased by 13.5%, the net result would be 99.65$.)

With more and more companies trying to go global and join the outsourcing economy, and with more and more hi-tech manufacturing shifting overseas, it’s only logical to expect that global trade will continue slow, steady growth whether it makes sense or not, but we’re not going to see exponential expansion anytime soon. As a result, while Global Trade Management software (GTM) sales will pick up in the US where advance filing, denied party lists, and other requirements are making GTM almost impossible without software support, GTM software is not likely to see the same sort of increase in demand in other countries. (Security regulation is also increasing in Europe, but not at the rate it is in the US, at least for the moment.)

In other words, GTM is a solid investment for buyers and vendors alike, but don’t look for rapid growth predicted by the ARC Advisory Group, in this article on realizing global trade management potential, just yet.

If a Deal Is Too Good To Be True, IT IS!

This is just as true in technology and services as it is in products. If you get four bids for a new technology platform and / or (integrated) services package and three are plus or minus 20% and one is 1/3 of the price, I guarantee that lowball bid is too good to be true. And if you did your homework, you’d instantly know it and disqualify it.

You buy a product or service because it’s cheaper to buy than to build or perform it in house. However, that product or service still has a cost to the vendor, in terms of manpower and resources — costs the vendor has to meet in order to deliver you a quality product or service. If the vendor doesn’t cover these costs, and make a fair profit, one of two things is going to happen — the vendor is going to go out of business trying to serve you at an unsustainable level or the vendor is going to deliver a significantly inferior product or service to stay afloat.

I’m reminding you of this because a number of companies have not only been looking for new solutions now that we’re into a slow recovery, but because a number of companies, desperate to reduce costs, have been rebidding everything under the organizational umbrella, including the supply management platform(s) and service contracts. And in doing so, many of them have been getting unbelievably low bids from a handful of vendors who are desperate to win (new) market share — and the companies are seriously considering these bids. These bids are unbelievable for a reason — they’re not real. They’re up front costs, and as soon as you sign on the dotted line, you’re going to be hit with “change fees”, “service costs”, “upgrade fees”, etc. if you want the same level of service being offered by the competition, who are all in the same ballpark at sustainable bids. Or, even worse, the vendor is just going to give you the platform or an initial spending report, and then disappear until renewal time because the cost only covers platform support, not project or customer support. Or, and this is the worst situation of all, the vendor is trying to build a new business (in a new vertical) and thinks it can use you as a marquis customer to attract new customers, who it will overcharge to make up for the loss on you. If it works, you’re in luck, but the vast majority of the time what happens is that either the vendor fails to deliver, because they didn’t understand the true success requirements or they didn’t understand how much it would cost and how long it would take to make you a success, and then shuts down the business. If you’re lucky, they just shut down the vertical and you get to keep using the platform until you can find a new vendor. If you’re, not, the whole vendor goes tits up and you’re left holding the empty bag.

The worst part is that every month, if not every week, I hear of yet another company who signs on the dotted line with one of these vendors offering “unbelievable” deals that “can’t be matched” — and, even worse, the company is one that should know better (because there are success stories that illustrate it understands many of the precepts of good supply management). Especially when it’s so easy-peasy to determine if a bid is reasonable or not.

It’s easy to determine a reasonable range for a (bundled) technology platform (and /) or service. All you have to do is build a should cost model. Let’s say you’re buying a SaaS e-Procurement platform and want regular project management support, best-practice training, and custom integration to your in-house technology platform. Then you know the vendor will have, at least, the following costs:

  • Platform Delivery & Maintenance
  • Account & Project Management Personnel
  • Development Personnel

If the SaaS license will require 1/50th of their data centre resources, then the base overhead to support you will be 1/50th of their data centre and support team costs. If you require about 20 hours a week of account and project management support and training, then you will require half of a senior resource who has expertise in your industry and categories. If the custom integration is expected to take two man years, than you will need the equivalent of two developers on the vendor’s staff dedicated to you.

Now, if the average cost to maintain a small data centre, or rent part of a data centre, that will support 50 similar-sized enterprise clients is 3M, then you can quickly estimate that it will cost the vendor 60K (+- 10K for a margin of error) just to have you on the books, before it lifts a finger. If the senior resource required to support you on your projects is a 120K to 150K resource, then it will cost the vendor 60K to 75K to dedicate this resource to you half of the time. And if the average developer with the necessary skills is going for 70K to 90K, that’s another 140K to 180K that the vendor needs to outlay to support you. Then, there’s the vendor’s cost of sale, which, depending on commissions structures and expenses, is probably in the 15% to 25% range, and the need for the vendor to make a fair profit, say 10% to 15%, to keep investors happy. If you add it all up, you get:

Cost $ Range
Platform Delivery & Maintenance 050K to 070K
Account & Project Management Personnel 060K to 075K
Development Personnel 140K to 180K
Subtotal 250K to 325K
Cost of Sale 040K to 070K
Profit 025K to 050K
Total 315K to 445K

This tells you that any bids you get in and around the 315K to 445K range are reasonable, that if you get any bids that are more than 600K, the vendor either doesn’t understand what you want or is trying to rip you off (up front), and that if you get any bids less than 250K, either the vendor is planning to not support you to the level you need to be supported, the vendor is planning to make it up later with “change fees” and “service fees” when you’re locked in to a long term contract and held captive, or the vendor is looking to make a poster child out of you and take unfair advantage of the relationship (and then leave you holding the empty bag if things go south).

Regardless of why the vendor gave you the unbelievable bid, one thing is clear. If you accept it, you will get screwed.

Is Your Supply Chain About To Get A Lot Leaner?

We already knew that food prices are rising considerably across the board. They’ve risen so much (29% in the past year) that the World Bank estimates that 44 Million people have been forced into poverty since last June as a result.

If this isn’t enough, thanks to the skyrocketing price of cotton (which has more than doubled in the past year, hitting all time highs), “clothing prices are set to rise 10% this spring” (BlazeMedia). Considering that the average household spends about 15% of their budget on food and 5% on clothing, which are not discretionary expenses, the average household is now looking at a total increase in their non-discretionary food and clothing expenses of 5%. Given that, after housing, food, clothing, transportation, health care, insurance, and debt payments, the average household had less than 15% of their funds for discretionary expenditures, this says that the average household now has less than 10% of their funds for discretionary expenditures. That’s a 33% reduction in discretionary funds in less than a year!

This says that any company that provides a discretionary product or service to an average consumer is now fighting over a market-share that might have shrunk by a 1/3rd. Someone is going to lose and someone’s market share is going to get smaller. This means that a number of supply chains are going to have to get a lot leaner this year for those companies to survive. Is yours ready?

Why Your Supply Chain Needs To Be Flexible

Thanks to economics, your forecasts will be right only 30% to 40% of the time, as per this recent article over on BBC News that asks why do economists get it so wrong. Whether you care to admit it or not, all forecasts implicitly assume that the general economic condition will stay the same, since that determines not only how much money your potential customers will have, but how much they will be willing to spend. But since the foundation of the economy — humans, resources, wars, natural disasters, technology, etc — are in a constant state of change and flux, all of the models used to describe the economy are flawed.

Thus, your forecasts are only likely to be right at the macro level. Since nearly every economic forecast will be right at some point, every product line forecast will be right at some point, but like a broken clock, may only display the correct volume 0.13% of the time. If you have years of past behaviour, you’ll be able to create a good forecast at the macro (year) level, but it will get less and less reliable as the time period shrinks, no matter how much you throw into your model. That’s why you need an adaptive and flexible supply chain that allows for relatively quick replenishment — so you can ramp up production and distribution when you need to, but not have too much inventory on hand when you don’t.